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Interest And Inflation Wonkery

August 30, 2010 12:46 pmAugust 30, 2010 12:46 pm

So I thought I’d produce a simple graphical summary of how I see the whole interest rates etc. thing. Why? Well, I think little
teachable models are always useful; and I always enjoy putting them together.

So here’s how I think about it: combine a Wicksell-type notion of a natural rate of interest — but it has to be a natural real rate of interest — with a Taylor-type description of monetary
policy. In the figure below, the flatter line (with a 45-degree slope) shows combinations of inflation and nominal interest rates at which the economy is at the natural rate of unemployment. Inflation will accelerate
if the economy is below that line, decelerate if it’s above. Meanwhile, the steeper line is a Taylor rule describing the central bank’s behavior: it raise rates if inflation rises, lowers them if inflation
falls. The line has to be steeper than 45 degrees, or the thing is unstable.

In this picture, long-run equilibrium is where the two lines cross, at point 1.

Now suppose there’s an expansionary change in policy: the central bank sets the interest rate lower for any given rate of inflation. This shifts the Taylor rule down and to the right:

So what happens? Initially the economy goes from 1 to 2: the interest rate falls. Over time, however, inflation rises, and so do interest rates. Eventually you end up at 3, with a higher rate of inflation and a higher
interest rate.

The implication, of course, is that a policy that lowers interest rates in the short run ends up raising inflation — and interest rates — in the long run. And, of course, a policy that raises rates in
the short run ends up reducing inflation.

How could you disagree with this story? Mainly, I guess, by denying that there really is any distinction between the short run and the long run — by arguing that inflation adjusts immediately. But this poses
some obvious reality issues. First of all, if inflation isn’t sticky, how is it that the Fed can set short-term interest rates at all? And it manifestly can. Second, experience overwhelmingly shows that inflation
changes only gradually in response to unemployment — see, for example, the experience of disinflation in the 70s and 80s.

OK, so the Kocherlakota dispute followed K’s very clear statement that the Fed’s current policy of low rates is deflationary. That’s sheer nonsense. And it remains disturbing both that
a Fed president would say such a thing, and that there were economists eager to defend him.